Wednesday, January 7, 2009

Types of Investment risk

Systematic Risk
There are two types of risk one risk is pervasive in nature such as market risk or interest rate risk and the other is that are specific to the issuer risk, business or financial risk.

Total Risk = Systematic risk + Nonsystematic Risk
= Market risk + Issuer risk

All securities have some systematic risk whether be it bond or stocks, it encompases interest rate, market and inflation risk. This part of the risk cannot be avoided because know matter how diversified your portfolio, the overall risk cannot be avoided. If the stock market falls sharply most stocks will be affected and if it rises most stocks will rise.

Nonsystematic Risk
The variability in a securities total returns not related to market risk is called non market risk or nonsystematic risk. The risk is unique to a particular security and is associated with such factors such as business of financial, liquidity etc.
Systematic risk is associated to broad macro factors affecting all securities and nonsystematic risk is attributed to factors unique to a particular stock or security.

Market Risk

Market risk is non diversifiable risk. This risk is a systematic risk and it is exposed market conditions including recessions, wars, changes in economy, tax law changes, even consumer preferences.

Reinvestment Risk

In the context of bonds there is YTM (Yield to Maturity) . YTM is promised yield if the bond is held till the maturity. The bonds declare periodic interest the periodic interest should also be reinvested at the same rate as YTM but since the interest rate fluctuates this reinvestment may not get the same rate and hence it is called reinvestment risk.

The other way out is opting for a cumulative option were compounding of interest is done automatically and paid to the investor on maturity. This risk here is the opportunity loss of being able to invest the periodic receipt at higher rate then the current bond rate.

Interest Rate Risk
The variability in a security's return resulting from the changes in the level of interest rates is called interest rate risk. Interest rate generally affects securities inversely. Financial planner while considering fixed income securities should opt for short term debt product if he thinks the price might rise in near future and on the other side it would be good idea to commit for long term funds of interest rates have reached historic peaks and may fall in the future.

Purchasing Power Risk (Inflation risk)
There is a chance that purchasing power of invested money may decline.
example to explain say today you have Rs 100 and you can buy 5kg of Sugar (Rs 20 per kg) , This money is invested at the rate of 8% and it will become Rs 108 after one year. The inflation rate is say 10% and after one year price of sugar is Rs 22 per kg. Now after one year with Rs.108 you can buy only 4.9 kg of sugar. so your purchasing power has decreased. basicaly value of your money has eroded.

Liquidity Risk
Liquidity is being able to sell and realize cash value of an asset with least possible loss of time and money. An investment that can be bought or sold quickly without significant loss is called liquid. Treasury bill has no liquidity risk were as a small cap stock listed on regional stock exchange may have substantial liquidity risk.

Regulation Risk
Investment in PPF is tax free and even the interest earned is tax free. now if the govenrment changes the law then this can have huge effect on the final earning of this investment. Dividends from stocks and mutual funds are tax free in the hands of the investors hence they are investor friendly (This rules can be changed by goverment and are matters of regulation) This investment products are attractive because of tax concessions. this is the risk associated with investments in such products.

Business Risk
The risk of doing bussiness in a particular industry or environment is called business risk example commodities like oil and petrol are highly price sensitive and government policy of subsidising this products sustantially affect the profitability on companies engaged in manufacturing and marketing this products.

International Risk
It includes country risk as well as exchange rate risk.

Exchange rate risk
All global investors faces the prospect of uncertainity in the returns after they convert the foreign gains back to their own currency. it is also called currency risk.
If indian investor invest in abroad in dollars now afterwards he has to convert back to indian rupees and the mean while dollar - rupee exchange rate can have a big impact on the final returns.

Country Risk
It is more of political in nature. People always consider investing in more stable and growing economy. It is more risky to invest in a country were there is no political or economical stability.

Conclusion
Every investor has his own comfort level with risk. The is no "right or wrong" amount of risk, it is very personal in nature. however more younger you are more risk you can take and as you grow old you can take less risk.

Most investor should consider and proper mix of stocks and bonds. The younger you are ratio of stocks should be higher and the more older you are ratio of debt products should be higher.

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